for years, regulation - capital requirement in particular - has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk. It is to be expected that financial institutions would maximise returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators.

Pointer from Tyler Cowen.
The diagnosis of regulatory arbitrage is correct. However, the prescription of better regulation needs to take into account the fact that all centrally planned incentive systems degrade over time. That is, over time, regulated institutions will find weaknesses in the system and come up with ways to maximize risk within the letter of the law.

That is why I argue for "spirit of the law" regulation. This is a very unpopular idea. But I think that if the government protects an institution, with deposit insurance for example, then executives should be liable for a collapse regardless of whether the risks they took met the letter of the law. And I think that prison should be the punishment. You don't want executives to assume that as long as their portfolios meet the letter of the law they need not worry about risk-taking.

Comments and Sharing

Wouldn't it be easier and less morally objectionable to simply end limited liability for upper management at government backed institutions? If all their personal assets were exposed, I imagine they would be much more cautious, even without the threat of incarceration.

In a corrupt society, regulations and laws cannot work. Bear Stearns, Merrill Lynch, AIG were unregulated and in principle their failure was supposed to send them into bankruptcy. But they and their creditors were big donors to powerful politicians, and so they were bailed out. In a crisis, the laws and regulations will be bent to meet the needs of the powerful.

In this environment, the "spirit of the law" approach you propose would only raise the risk/costs of falling under the regulatory umbrella, cause more activity to move to the "unregulated" space, in which government protection would be purchased at a much lower price through campaign donations and bribes.

And if there's no unregulated institution, and you punish risk-taking, then how are banks to fulfill their function of borrowing short and lending long -- an intrinsically risky activity?

Todd has the right idea. The best regulation works with naturally self-regulating forces. The news today should be replete with stories of shareholder lawsuits, the claw back of management compensation from failed financial institutions, and the abject punishment of certain individuals via civil litigation. But it is not.

Companies have historically shopped for state corporate charters based on their favorable treatment of management liability. Perhaps shareholders will do some shopping of their own, and policymakers should look at facilitating the process.

What about unintended consequences? One, it's a huge disincentive to taking those management positions. Do we want lower-quality management in those firms? Two, it would change bank behavior pretty drastically, I'm thinking. Do we want to limit profit-maximizing behavior on the part of banks in general? I agree that a lot of the recent activity has been stupid and value-destroying, but hanging the threat of prison (or personal bankruptcy) over people will change their incentives in much more far-reaching ways. How risk averse do we want lenders to be? Are we willing to accept a lower base level of economic growth as a tradeoff for less systemic risk?

So I don't know. The simplicity and strictness appeal to me, but I get a vague sense of Monday-morning-quarterbacking from this proposal.

Maybe we could do better with focusing on transparency and letting investors better allocate their capital? Requiring more disclosure and fixing the broken ratings system would make it easier for investors to figure out ahead of time which banks are adequately managing risks.

> That is why I argue for "spirit of the law" regulation. This is a very unpopular idea.

I'm glad to hear that at least. :)

Again, why do you imagine that giving officials power to punish according to the "spirit of the law" will be used for good?

I'm certain you are familiar with the idea of regulatory capture. It should be obvious (a trillion dollars obvious) that our financial regulators are mentally aligned with Wall Street and are motivated to protect Wall Street's interests.

Giving them new and unwritten powers will not change that, and it will not stop the next round of banker's leverage games, whatever shape it may happen to take.

"I think that if the government protects an institution, with deposit insurance for example, then executives should be liable for a collapse regardless of whether the risks they took met the letter of the law. And I think that prison should be the punishment." I would prefer drawing and quartering as the punishment. That would effectively *end explicit federal guarantees*, which I would like to see. But pj is right: that wouldn't stop the federal government from bailing out any corporation they pleased, even in the absence of an explicit guarantee.

I think it was from this blog that I read the post from Michael "Liar's Poker" Lewis that said that the investment banks used to be privately owned clubs investing primarily their own money, and then they got blown open to shareholder-funded ventures.

It seems things worked much better when they were private. They were very cognizant of the risks to their pots of gold.

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